Defined benefit plans, cash balance plans, and other pension structures can be excellent retirement vehicles. But benefits aside, there can be issues with these plans. Specifically, how much do you know about the pension excise tax?
Since these plans are so complex, funding problems often come into play. One issue we see all too often is overfunding.
Overfunding can be an issue because, at termination, the overfunded amount is taxed to the company along with an excise tax. This issue is technically called reversion.
This guide will examine the pension excise tax and show you a few ways to eliminate it. With a bit of planning, you typically can avoid costly penalties and taxes.
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Excise tax was first established by Congress in 1986 as a method to protect employees of large businesses from corporate raiders acquiring the company and then liquidating the pension and keeping the excess funds for themselves.
But corporate raiders are largely a thing of the past. Most people faced with excise tax penalties are small business owners with less than 10 employees. Their plans were funded with good intentions, but they got a little out of control thanks mostly to large investment returns.
What is the Pension Excise Tax?
The truth is that funding defined benefit plans can be a juggling act. Investment returns can be volatile, compensation levels can vary, and funding ranges can be broad.
But one thing that business owners often overlook is the return on plan assets. The asset balance is driven mainly by contributions and reflects earnings on the investments, like dividends, interest, and capital gains.
Large fluctuations in investment returns can result in underfunding or overfunding. This concern is more common than most think. When a plan is terminated, it can result in a pension excise tax.
How to Legally Avoid the Pension Excise Tax
Many excellent strategies can work well for plans that have minimal overfunding. But what if a plan is overfunded by $1 million or more?
When this is the case, I would look to a strategic sale or a plan merger. This approach can be complex, and it does require careful legal and tax review. But with significant overfunding concerns, this is often the best solution.
The structure works similar to the following:
- a company acquires the company that holds the pension assets; and
- the company that was acquired pays capital gains on the sale.
The company that acquires the company with the pension will usually pay a 20% to 35% discount on the overfunded balance. The two plans are merged in a stock purchase transaction. The purchase price typically gets long-term capital gains treatment.
This type of transaction is the most complex solution but should get consideration in large overfunding matters. We often assist clients considering this option.
Tax Filing Concerns
You would pay the pension excise tax with Form 5330, Return of Excise Taxes Related to Employee Benefit Plans. Interest is charged on any unpaid tax by the due date, even if an extension was filed.
Late penalties are also steep. Penalties are assessed at 5 percent of the unpaid tax for each month that a return is not filed by the due date. This penalty is capped at 25%. The good news is that you can file an extension. This penalty will not be levied if you can show reasonable cause. You simply would need to attach a statement to Form 5330 that explains the reason.
Failure to pay the excise tax when due also creates another penalty. It is ½ percent of the unpaid tax balance for each month. The penalty is capped at a maximum of 25 percent of the unpaid balance.
Defined benefit plans are very complex. Even though they offer outstanding tax and retirement benefits, they can have some issues if you are not careful. This is where the pension excise tax.
Overfunded plans are prevalent, but thankfully some creative solutions can mitigate the concern. So it would help if you did as much planning as possible to avoid reversion.
If you find yourself in an overfunded situation, make sure you reach out to us to discuss your options. Some essential planning can go a long way.